A Question Not to be Underestimated: Asset or Business Acquisition?

A transaction is either accounted for as a business acquisition under IFRS 3, Business Combinations, or, if it is not a business combination, in accordance with the appropriate standard for an asset purchase (for example: IAS 16 Property, Plant and Equipment; IAS 38 Intangible Assets; or IAS 40 Investment Property).

The question is important (and there are significant consequences to getting the answer wrong or not considering the question at all!), because in a business combination:

  • Goodwill or a gain on bargain purchase is accounted for;
  • Assets acquired and liabilities assumed are accounted for at their fair values rather than being recognized at their relative fair values in an asset purchase;
  • Directly attributable acquisition costs are expensed versus capitalized as part of the asset purchased;
  • Deferred tax assets and liabilities are recognized in a business combination;
  • IFRS provides guidance on recognizing contingent consideration but there is no guidance in the standards applicable to asset purchases;
  • The disclosure requirements are considerable in the financial statements for a period in which a business combination is completed, and the same disclosure applies in any year where an acquisition is made subsequent to the report date but before the financial statements are issued; and
  • Also note that some of these differences continue in future periods, such as impairment and depreciation/amortization.

An entity first needs to determine whether the assets acquired and liabilities assumed constitute a business (IFRS 3.3). If they do not meet the definition of a business, then the default is to account for the transaction an asset purchase.

Appendix A to IFRS 3 defines a business as, ‘an integrated set of activities and assets that is capable of being conducted and managed for the purpose of providing a return…to investors or other owners, members or participants.’  A business therefore consists of inputs and processes applied to those inputs that have the ability to generate outputs. Therefore, outputs themselves are not required.

Input: are economic resources, such as intellectual property, access to necessary materials, employees and non-current assets such as intangible assets or the rights to use non-current assets.

Process: is any system, standard, protocol, convention or rule, such as strategic management processes, operational or resource management processes. Administrative processes are specifically excluded.

Output: is a return in the form of dividends, lower costs or other economic benefits

You should note the following in applying the definition:

  • If the transaction does not include both inputs and processes then it is not a business combination.
  • Some processes must be included in the transaction, but all processes used by the vendor need not be included. Some necessary processes may be provided by the acquirer on integrating the business with their own operations.
  • A business need not have liabilities.
  • The set of assets and activities must be capable of being conducted and managed as a business by a market participant. Whether the seller operated the set as a business and whether the acquirer intends to operate it as a business is not relevant.
  • There is a rebuttable presumption that an asset that includes goodwill is a business.
  • The elements of a business vary by both industry and structure of an entity.
  • New businesses often have few inputs and processes and only one (or no) outputs. In this situation, other factors must be considered, including whether the set:
    • Has begun planned principal activities;
    • Is pursuing a plan to produce outputs; and
    • Is expected to obtain access to customers to purchase those outputs.

The determination of whether a transaction is a business acquisition or an asset purchase is a judgement call that must be disclosed.

The Application Guidance provides more detail that is useful in applying IFRS 3, including the following.

The definition of a business includes inputs and processes and may also result in outputs, although outputs are not necessary for a business to exist. A process is defined as, ‘any system, standard, protocol, convention or rule’ (IFRS 3.B7) that when applied to inputs creates, or has the ability to create, outputs. Examples of processes include strategic management, operational and resource management. Inputs are economic resources that create, or have the ability to create, outputs when one or more processes are applied, and include intangible assets or the rights to use non-current assets.

‘To be capable of being conducted and managed for the purposes defined, an integrated set of activities and assets requires two essential elements – inputs and processes’. Therefore both assets and processes must be included in the acquisition, even though all necessary processes need not be acquired (some processes may be contributed by the acquirer) (IFRS 3.B8). If no processes are included, then the transaction is an asset purchase; if this was not the case, then any asset purchased for use in an existing business would meet the definition of a business, which would be non-sense.

Furthermore, processes are described as ‘activities’ in IFRS 3.B8, which is consistent with the English language definitions of the word: (i) as a noun, ‘a series of actions or steps taken’ and (ii) as a verb, ‘perform a series of mechanical or chemical operations on something in order to change or preserve it.’ The purchase of in-place leases, for example, represents economic inputs and not a process; the leases represent a right to benefit from non-current assets. There are no activities inherent in a rent-roll, instead leasing and other management processes are applied to it.

Where the acquisition includes both inputs and some level of process (over and above administrative functions, which are specifically excluded by the definition) the determination can involve significant judgement. The IFRS Interpretations Committee White Paper of May 2013 addressed the application of this principle in practice by different sectors, including the real estate sector, and in different jurisdictions.

One view in practice is that the processes acquired must have a level of sophistication that involves a degree of knowledge unique to the assets being acquired for a business to exist. Common themes in the responses received include:

(a)    Examples of significant management processes that management views as being integral for a business to exist, include marketing, tenancy management, financing, development operations and other functions that are typically undertaken by the parent company or external management.

(b)    The acquisition of an investment property together with the employment of key management personnel of the vendor is a strong indicator of a business.

(c)     Other processes such as cleaning, security and maintenance are generally not considered to be significant processes. Therefore, a transaction that only includes those or similar processes is generally treated as an asset purchase.

Note that these necessary processes meet both the definition in IFRS 3 and the English language definition, while in-place leases acquired do not.

The view that a level of sophistication is required is predominant in Europe and Australia and is consistent with the requirement that processes be at a more supervisory or management level (as per the definition: strategic management, operational and resource management).

The view from respondents using US GAAP (which is nearly identical to IFRS guidance) is that ‘any process that, when applied to an input or inputs, create or have the ability to create outputs, gives rise to a business.’  Therefore, transactions are more likely to result in business acquisitions than asset purchases in the US GAAP world.

Under Canadian Accounting Standards for Private Enterprises (ASPE) the relevant standard is 1582 Business Combinations, which is a copy of IFRS 3 Business Combinations. Therefore, the guidance surrounding IFRS can also be applied to the same asset or business combination question under ASPE. In applying the GAAP hierarchy in ASPE (standard 1100 Generally Accepted Accounting Principles), the first consideration would be IFRS and not US GAAP. This is logical given the fact that 1582 and IFRS 3 are identical.

The International Accounting Standards Board (IASB) carried out a Post Implementation Review (PIR) of IFRS 3 in 2014/2015. The review found that stakeholders find it difficult to apply the definition of a business in practice. The IASB issued an exposure draft in June 2016 which proposes: amending the language used in the standard, adding illustrative examples and simplifying the application of the standard in some situations. The comment period closed on October 31, 2016. Watch this space for an IFRS Condensed piece on the final amendments to the standard.

Implementing Hurdles with the New Revenue Recognition Standard (IFRS 15)

The following article was originally published by Wiley Insight IFRS.

Canada: Crossing the Rubicon – High threshold of evidence required

It seems to me that alternative uses that remain theoretical would be a sufficient “practical limitation” to any ability to direct an asset to an alternative use and to cross that Rubicon would require a very high threshold of evidence. For example, subsequent events that show alternative uses have crystalised for the very same asset.

Paul Rhodes 

  1. Determining if a contract exists

Some practitioners have questioned the effect of contract termination provisions where only one party can cancel the contract. This would occur for instance when a service provider is committed to providing services for a specified period but the customer can terminate the contract any time without penalty.

Question

Do you believe that:

  • the contractual period only includes the period for which the entity has an enforceable right to obligate the customer to purchase the goods or services? or
  • the contractual period is the specific duration for which the entity is obligated to continue to perform?

Whether an agreement with a customer meets the criteria in paragraph 9 is determined at contract inception, which includes that the entities are committed to perform their obligations under the agreement. The explanatory paragraphs that follow the criteria go on to state that a contract “creates enforceable rights and obligations” and that “enforceability…is a matter of law.” Therefore, a legal contract is not necessarily the same as a contract for financial reporting.

The standard is clear only in scenarios where the arrangement: can be unilaterally cancelled by either party; the entity has not yet transferred any promised goods or services; and has not yet become entitled to receive any consideration. In this case the arrangement would not be considered to be a contract.

Outside of this narrow example, such as when only the customer can cancel the contract at any time, an entity has to consider the practices and processes for establishing a contract with customers, and they may vary by legal jurisdiction, industry or type of entity. While judgement will be required, note that the commitment required of both parties – which is assessed at contract inception – is a lower bar than the legal criteria of enforceability.

The contractual period would not be limited to the period that can be enforced by the entity. It is likely that the contractual period would be the same as the initial contract term to which the parties committed.

2.  Onerous contracts

While IAS 11 Construction Contracts has been superseded by IFRS 15, the onerous contracts guidance in IAS 37 Provisions, Contingencies and Contingent Assets remains the sole piece of literature addressing loss-making contract situations. Concern has been expressed by some practitioners that the basis for measuring onerous contract provisions under IAS 37 is dissimilar to that of loss-making contracts under IAS 11. This is because IAS 37 has an unavoidable costs approach when IAS 11 considers all costs directly attributable to the contract.

Question:

Do you think that the approach to measuring loss-making contracts has changed with IFRS 15? Are you aware of practitioners changing the measurement basis for their loss-making contracts?

It is conceivable that there will be differences in accounting for loss making contracts in the following scenarios:

First, IAS 11 Construction Contracts measured total contract costs against total contract revenue. Included in contract costs are those costs that are attributable to the contract, such as insurance, design and other overheads. Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the unavoidable cost of an onerous contract is the lower of the cost of fulfilling the contract obligations and the costs and penalties of failure to perform the work. Except for extraneous circumstances, there is likely to be a constructive obligation for the contractor to perform the work. For a fixed fee construction contract, the unavoidable costs will still be included in the measure of the loss under IAS 37. However, the directly attributable cost under IAS 11 is a more comprehensive measure of project cost and may therefore result in smaller losses being recognised under the new revenue framework.

Secondly, IAS 11 included criteria – all three parts of which needed to be met – for an entity to group apparently separate contracts, or components, into a single contract for financial reporting purposes. That same grouping was also used when determining whether the contract for financial reporting was loss making. IFRS 15 also lists three conditions for grouping contracts for financial reporting purposes, however, only one of the three need to be met for individual contracts to be grouped. This may give rise to different financial reporting contracts under the new revenue regime, which could have a significant effect on whether a loss exists.

3.  Transaction price – minimum commitment

In some industries, for instance telecommunications, the customer signs up for a certain service level for a fixed term (for instance a 24 month 5GB data plan). The customer also commits to maintain a minimum level of service (for instance a 1GB data plan) throughout the contract term that is possibly lower than the service level subscribed at inception. Upon entering the contract, the customer receives a free or discounted good or service as an incentive for entering the contract. The contract has two performance obligations (the core service and the incentive) to which transaction price needs to be allocated. The question has arisen as to what is the transaction price?

Question:

Do you believe that the transaction should reflect the minimum service commitment or the initially contracted service level?

The total transaction price is relevant in allocating the price between the deliverables of the discounted good and the service commitment over the term. In measuring the consideration, paragraph 49 requires the entity to assume the deliverables are transferred to the customer, “in accordance with the existing contract and that the contract will not be cancelled, renewed or modified.” In a contract for telecommunication services, the customer is usually able to vary the service level (number of minutes of air time and data level) within the original contract terms.

Typically, if the customer’s use of minutes or data exceeds their plan the excess is charged at premium rates. The customer is also able to vary the service level at any time during the contract term by giving the defined period of notice to the entity. There is no guarantee that the service level will not be reduced to the minimum level that was promised in the contract.

The question is also whether this variability is to be accounted for as variability in the transaction price under IFRS 15. The examples listed in paragraph 51 are all changes in the consideration only with no commensurate change in the promises made by the entity or the customer. Since in our example, the change in the transaction price varies along with the level of service to be delivered by the entity (bandwidth, for example) it should not be treated as variable consideration in measuring the transaction price.

The transaction price to be measured is explained in paragraph 47 as:

“…the amount of consideration to which an entity expects to be entitled in exchange for transferring promised goods or services to a customer”

The only promises made in the contract are the minimum service levels. If the contracted service level is in excess of that, it should not be considered to be a promise because there is no commitment over the duration of the contract term. The ability of the customer to increase the level of service during the term is an option only and no promise exists that they will do so.

4.  No alternative use assessment

In the aerospace and defence industries, companies may conclude that a good has no alternative use (therefore meeting one of the criteria to be recognised over time) under current market conditions, because no other customer exists. However, the company may expect market conditions to change over the contract period so that the good could have alternative use as the market develops. The question has arisen as to whether the no alternative use criteria would be met in such circumstances.

Question:

Do you believe that expected change in market conditions should be taken into account when assessing no alternative use?

If the entity’s performance creates an asset with no alternative use then revenue for performance should be recognised over time. If there are alternative uses and none of the other criteria for satisfying a performance obligation over time are met, then the revenue is recognised at a point in time.

An absence of alternative uses can arise through either substantive restrictions included in the contract terms or through practical limitations. In the aerospace and defence industries, the application issue raised is one of practical limitations and not of contractual restrictions.

The standard requires alternative uses, or the lack thereof, to be determined at contract inception and describes this process as an “assessment” which implies that judgement is required. The basis of conclusions refers to “practical limitations on the entity’s ability to readily direct that asset for another use” and provides the example of selling the asset to another customer. Selling the asset to another customer may not be practical where there is a degree of customisation that would require rework, the cost of which would result in a loss. This is the case for the satellite in illustrative example 15.

Clearly several moving parts would come into play to make this judgement, not least of all the term of the contract. It seems to me that alternative uses that remain theoretical would be a sufficient “practical limitation” to any ability to direct an asset to an alternative use and to cross that Rubicon would require a very high threshold of evidence. For example, subsequent events that show alternative uses have crystalised for the very same asset would seem to be required.

5.  Movie rights – determining the point in time when control transfers

Uncertainty exists at what point in time movie production companies should recognize revenue when licensing out all broadcasting rights for a movie to a distributor. These rights may include all distribution channels like theatres, home video and television. However these rights may come with restrictions, for example, home video rights will not be available until 12 months after a theatre release.

Question:

Do you believe that in the above situation it would be appropriate to recognize all fixed transaction prices on day 1?

The license represents a single performance obligation, being a right to use the entity’s intellectual property (the rights to the movie production) as it exists at the time the license is granted.

Example 59, paragraph IE305, states that the point in time to recognize revenue is “when the customer can direct the use of, and obtain substantially all of the remaining benefits from, the licensed intellectual property.”

The remaining question is: what that point in time is for the home video rights: whether it is day 1 or 12 months after the theatre release date. In deciding this question we would apply the principle of control that underlies the recognition of revenue. Even though the licensee cannot exploit the intangible asset for a period of time in one of its applications, the fact that the licensor is prevented from licensing the intangible for home video use to another party, from otherwise using it and from using the intangible as security (which we assume are terms of the license agreement that would be negotiated by the licensee) would suggest that the entity no longer has control over the asset. In effect the licensee is able to enforce the legal terms of the license to “prevent other entities from directing the use of, and obtaining the benefits from, an asset,” which is an example of control passing in paragraph 33. The corollary of the licensee obtaining control is that the entity must no longer have control, which would be the case here.

The concept of revenue not being recognised before the licensee is able to obtain economic benefits in paragraph B61 appears to be superseded by the broader concept of control described above and in paragraph 38. In addition the example of revenue only being recognised once a code is delivered to the customer is not the same. Note that paragraph B62 explicitly excludes restrictions of time from the consideration of determining the nature of the rights being transferred.

Therefore the point in time for recognising the fixed revenue would be day 1.

This conclusion is consistent with the indicators of the transfer of control at a point in time in paragraph 39. For example, physical possession has likely transferred to the licensee and the licensee has assumed the risks and rewards of holding that title.

If any of the fixed consideration for the license, including for the home video release, is not due on signing the license then it should be discounted and the finance revenue recognised over the payment term, if material.

If the terms of the license are such that the entity is required to perform other obligations prior to the licensee being able to exploit the home video market, then the conclusion may need to be reconsidered. This is because the license itself may not be distinct and/or the license may represent a right to use intellectual property that changes over the term. For example, perhaps the point in time is not reached until the movie production has been significantly remastered or reengineered for the home market. This concept is discussed in paragraph B57.

6.  Indirect sales with subsequent repurchase and lease transactions

In some industries, such as automotive or telecommunications, companies offer their end customers to either lease or buy their product (car or mobile device). When such transactions are contracted through indirect channels, the company first sells the product to the dealer. Subsequently, if the end customer opts for the lease, the company buys back the product and leases it to the end customer. Some practitioners have questioned whether it is appropriate to recognize the sale of the product to the dealer in the first place, knowing that the company is implicitly committed to buying back the product and may have a history of demonstrating such a practice.

Question:

  • Are you aware of diversity in practice in such transactions under current GAAP?
  • Do you believe the accounting would change under IFRS 15?

We have no experience of such diversity in practice. For entities that recognise the initial transaction as a sale, a change on adopting the new revenue standard may be necessary depending on the specific terms of the arrangement.

For example, under IFRS 15, the entity would have to be satisfied that the initial sale contract has commercial substance and that it is probable that the consideration will be received. Commercial substance requires that there is some effect on the “risk, timing or amount of future cash flows.”

In addition, which entity (the automotive manufacturer or the dealer) controls the product may provide some insight as to whether the arrangement is one of inventory held on consignment by the dealer. For example, the dealer may be required to transfer vehicles to other dealers at the direction of the manufacturer. Similarly, the dealer may be acting as the manufacturer’s agent in making sales to the end customer.

Renewable Terms, Licences, Variable Consideration and other Contract Terms in the New IFRS 15 Revenue World

This article was originally published by Wiley Insight IFRS.

  1. How will the new revenue standard apply to contracts with renewable terms?

Any contract that is renewed at the time of complete satisfaction of the contractual performance obligations would be treated as an entirely new contract for revenue recognition purposes. If a contract is renewed prior to that point then an entity needs to consider the effect of the renewal and any changes in terms in relation to the remaining deliverables under the contract.

A contract that includes renewable terms, such as a modification of either the price or quantities deliverable under the contract, may be treated as part of the existing contract if the remaining goods and services are not distinct and form part of a single performance obligation that is partially satisfied at the date the modification took place. Any adjustment to the total transaction price or the performance obligations under the modified contract is accounted for as a cumulative adjustment to revenue (IFRS 15.21(b)).

If the circumstances do not meet paragraph 21(b) then the modified contract is either an entirely new stand-alone contract to which IFRS 15 is applied (paragraph 20) or it represents the termination of the existing contract and the creation of a new contract (paragraph 21(a)).

  1. Under existing IFRSs there has been debate about the appropriate revenue recognition for the sale of residential units in multi-storey apartment developments. Will IFRS 15 change the way in which those transactions are accounted for in your jurisdiction? If so, how and why?

Revenue recognition under IFRS 15 is based on control of the asset. In accordance with paragraph 35, revenue could be recognized for the sale of residential units in an apartment development when the entity does not have an alternative use for the asset created by performance of the contract and the entity has an enforceable right to payment for performance completed to date.

As described by illustrative example 17 Case B, the two criteria could be satisfied by, respectively, a contractual restriction preventing the entity from transferring the unit under construction to another buyer and when the entity’s right to payment of all the consideration for performance can be legally enforced against the customer.

Applying the same facts in this example to international financial reporting pre-IFRS 15 requires application of IFRIC 15: the contract is for the sale of goods because the buyer is not able to specify the major structural elements of the real estate and because the supply of materials is required. Therefore all the conditions in IAS 18 paragraph 14 must be met for revenue to be recognized. For certain real estate contracts the conditions can be met continuously allowing revenue to be based on the stage of completion. However, for the sale of a residential unit it seems likely that the entity will retain the risks and rewards of ownership until ownership passes to the buyer so revenue is only recognized at closing.

It seems likely that IFRS 15 will result in revenues being recognized over time, although the application of the new standard to contracts for the sale of units will depend on the exact terms of those contracts.

  1. How does the revenue standard allocate the transaction price when a bundle of goods or services is sold at a discount?

When a bundle of goods and services is sold under a contract the transaction price is allocated based on the relative stand-alone selling prices of the goods and services to be transferred, with the objective that the amount allocated depicts the amount that the entity expects to be entitled to in exchange for transferring the promised goods or services.

When the sum of the stand-alone selling prices for a bundle of goods and services exceeds the promised consideration the default method for allocating the discount is proportionately to all performance obligations in the contract, which is consistent with the method of allocating the transaction price.

As an exception to the default method, if there is observable evidence that the entire discount relates to only one or more, but not all, performance obligations then the discount is allocated appropriately. This allocation exception can be applied only when the criteria described in paragraph 82 are met, the objective of which is that the entity needs to have sufficient information to be able to allocate the discount to specific goods or services (or bundles of goods and services) within the contract.

While the criteria in themselves may not be immediately intuitive, taken together with illustrative example 34, they are more readily understandable.

  1. There are many different types of licences of intellectual property. Under IFRS 15, for some licences, an entity recognises revenue at the time the licence transfers to a customer. For other licences, an entity recognises revenue over a period of time. What factors determine whether an entity should recognise licence revenue at a point in time or over time? Do you believe the guidance provided in IFRS 15 will be operational in practice? If not, why not?

For simplicity, consider a contract under which the promise to grant a license is distinct from other deliverable goods and services. The point in time or period over which the entity satisfies a performance obligation for a deliverable item is dealt with in paragraphs 31 to 38 of IFRS 15; this guidance is applied to a distinct license in paragraphs B56 to B62.

The revenue recognition for a license between recognition at a point in time or over time is determined by whether a customer can direct the use of, and obtain substantially all of the remaining benefits from, a license at the point in time at which it is granted. The distinction is applied by considering whether the license conveys a right to access the intellectual property as it exists throughout the licence period, or a right to use the entity’s intellectual property as it exists at the point in time at which the licence is granted.

Therefore if the intellectual property over which the customer obtains rights changes over the license term then the customer cannot obtain substantially all of the remaining benefits from the license at the grant date. This is the distinction between a right to access (changing) intellectual property and a right to use (fixed) intellectual property.

The principle described is defined by the criteria in paragraph B58, all of which must be met if the license is considered a right to access the entity’s intellectual property.

The complexity of accounting for revenues arising under licenses is perhaps indicated by the fact that the standard includes so many illustrative examples on the subject.

Despite the number of illustrative examples, the application of these rules may pose problems in practice. For example, for a license of software which includes any updates for a period of time, an entity must consider whether it will ‘undertake activities that significantly affect the intellectual property.’ The phrase ‘significantly affect’ could be read in relation to the criteria in paragraph 33, in terms of ‘the potential cash flows (inflows or savings in out flows) that can be obtained.’

It is conceivable that rolling out later versions of the software could represent enhancements to the intellectual property from the customer’s perspective which should therefore be accounted for as a right to access that property as it exists throughout the license term. It is also likely that the nature of updates to be rolled out during the term, if indeed any will be, cannot be determined. Illustrative example 54 suggests that ‘because the software is functional when it transfers to the customer, the customer does not reasonably expect the entity to undertake activities that significantly affect the intellectual property.’ This seems too simplistic a statement for this industry.

  1. Do you anticipate any difficulties in applying the new standard’s requirements relating to the estimation of variable consideration? If so, in which circumstances and why?

Where variability exists in the amount of consideration receivable under a contract, the entity is required to make an estimate. The standard allows two methods of estimation: either the expected value, being the ‘sum of the probability-weighted amounts in a range of possible consideration amounts,’ or the most likely amount, being the ‘single most likely amount in a range of possible consideration amounts.’

Practical difficulties are likely to arise in a number of circumstances. For example, in determining the probability weighted amounts for the expected value method where the entity has individually unique contracts. The standard states that the expected value method may be appropriate where the entity has a large number of contracts with similar characteristics. However, the standard apparently only allows two methods of consideration estimation. If an entity has a number of contracts with dissimilar characteristics, each with a range of possible consideration amounts, the expected value approach would still have to be applied to each contract because the other method would not be appropriate.

In addition, an entity is required to consider a “reasonable number of possible consideration amounts” but a reasonable number is not defined. If there is a continuous range of possible consideration amounts under each dissimilar contract how many possible amounts should be considered in the estimation exercise?

As is often the case, the estimation of any amount can be based on accumulated historical experience. There is considerable scope where the lack of such knowledge would mean estimation is inhibited. For example, where an entity is required to refund to a customer some or all of the consideration received a refund liability is measured as the amount of consideration recognized for which the entity does not expect to be entitled. Similarly, the transaction price includes variable consideration only up to the constraint.

A lack of historical experience is likely to occur where an entity establishes a new business or product or sells existing products or services to a new customer segment which may have different characteristics rendering past experience irrelevant.

Canada: Disclosure collage

The following article was originally published by Wiley Insight IFRS.

The detail required for revenue under contracts with customers that have not yet been recognised poses a practical issue in that for many entities this information is likely to be outside of the accounting system. There is therefore a need to assemble the required disclosure which for many entities is likely to add to the Excel collage supporting the financial reporting, with all the inherent risks over completeness and manual errors.”

  1. Which types of transactions will the new standard have the greatest impact on and which industry sectors will be most affected?

The previous revenue standard used a risk and reward model for recognition, such that revenue was recorded if the significant risks and rewards of ownership had transferred to the customer. The new standard applies a control based model, such that revenue is recognised when control over the good or service passes to the customer. While the actual effect on reported revenues may not be substantial for many sales transactions because risks and rewards pass at the same time as control there will be a need for many entities to rigorously apply the new model to their revenue streams to ensure proper reporting.

Under IFRIC 15 the percentage of completion method was allowed for construction projects where the criteria in IAS 18.14 (the first of which is the transfer of the significant risks and rewards of ownership) were continuously met as construction progressed. With the change from a risk and rewards model to a control model, there may be changes required in the timing of recognising revenues from construction contracts.

IAS 18 included very limited guidance for recognising revenues where a contract comprises separately identifiable components. The guidance in IFRS 15 is significantly more detailed, and includes guidance for identifying the performance obligations in a contract and for allocating the transaction price between them. The circumstances in which the residual approach can be used to allocate the transaction price have been narrowly defined.

Any industry in which entities typically enter into contracts with multiple deliverables will be affected. Such arrangements are common in the telecommunications and software industries but also arise, for example, where any tangible product is sold along with either installation services or a maintenance contract.

  1. Do you anticipate that preparers will have difficulty identifying individual performance obligations and allocating the transaction price across them? If so, are there particular types of transactions where you believe this will be particularly problematic?

A performance obligation is a promise in a contract with a customer to transfer to the customer either: a good or service (or a bundle of goods and services) that is distinct, or a series of distinct goods or services that are substantially the same and have the same pattern of transfer.

Determining whether identified goods and services are distinct will often require a degree of judgement given the criteria that must be met: the customer must be able to benefit from the good or service either on its own or together with the customer’s existing resources and the good or service must be distinct within the context of the contract.

Software entities are again a good example of such transactions because a licence to software is often sold along with services to integrate the software with the customer’s existing systems. Determining whether a licence to software is distinct from the integration services may be a fine line, which is ultimately determined from the customer’s perspective despite the additional guidance provided in paragraph 28.

The transaction price is allocated to each performance obligation on a relative stand-alone selling price basis. The best evidence of a stand-alone selling price is an observable price when the entity sells the good or service in similar circumstances and to similar customers. When a stand-alone selling price is not available the amount that the entity expects to receive in exchange for each performance obligation must be estimated considering all information that is reasonably available.

The difficulty in such estimation will be exercising judgements consistently across contracts and across group entities.

  1. Do you anticipate that preparers will have difficulty determining whether a promised good or service is a performance obligation satisfied over time if it is unclear that the customer obtains control of the good or service over time? If so, are there particular types of transactions where you expect this may arise?

A good or service is a performance obligation satisfied over time if one of the following criteria is met:

(a)  The customer simultaneously receives and consumes the benefits provided by the entity’s performance as the entity performs;

(b)  The entity’s performance creates or enhances an asset that the customer controls; or

(c)  The entity’s performance does not create an asset with an alternative use to the entity and the entity has an enforceable right to payment for performance completed to date.

This may arise in the software industry where a customer contracts to purchase both a license for the entity’s own software and also integration services. If the software licensed to the customer can be used on a stand-alone basis prior to it being integrated with the customer’s other hardware and software systems then a conflict exists as to when the customer takes control of the license: either on signing and delivery for the stand-alone use (because the customer obtains control of the asset), or as a bundle with the integration services (which could satisfy either b or c above, depending on the circumstances).

  1. Do you anticipate that an entity will encounter practical difficulties in preparing some of the required additional disclosures? If so, which disclosures and why?

The level of detail required to be disclosed is significantly increased from the prior revenue standards. There are two areas that may be problematic: first, revenue under contracts with customers that have not yet been recognised because the performance obligation has not been discharged (paragraphs120-122), and second the level of qualitative disclosure required.

The detail required for revenue under contracts with customers that have not yet been recognised poses a practical issue in that for many entities this information is likely to be outside of the accounting system. There is therefore a need to assemble the required disclosure which for many entities is likely to add to the Excel collage supporting the financial reporting, with all the inherent risks over completeness and manual errors.

Qualitative explanations and descriptions are required throughout the disclosure section of the standard. Examples include: an explanation of the timing of satisfying performance obligations and the timing of payments; detailed descriptive information about performance obligations; and a description of when future revenue will be recognised.

In applying the standard, the qualitative disclosures required are not defined. Therefore entities will have to rely on the general principle regarding the objective of disclosures: to disclose sufficient information to allow users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers.

The standard includes concessions for disclosures during the transition period: for example entities need not present qualitative information required by paragraph 28 of IAS 8 for the prior period.

  1. What are some of the key issues an entity should consider when planning to transition to the new standard?

Issues to be considered in the run up to adoption of the new standard include:

  • As with any new accounting standard that has an effect on financial performance, entities must consider the effect on the timing of revenue recognition and whether loan covenants will still be satisfied. If the changes in recognising revenue will mean covenants are breached the terms of loan agreements should be raised early with lenders.
  • Similarly, early communication with investors would be desirable once the effect on operating results is determined to set expectations and avoid surprises.
  • The transition method to be adopted is a decision that should be considered and concluded early.
  • Entities should consider desirable system and process changes in order to generate the required information for both accounting and disclosures.
  • For consolidated groups the consistency of exercising judgements and making estimates should be determined by the parent and disseminated to group entities.
  • In Canada the measure of income used for income tax purposes starts with income determined under GAAP unless the tax legislation requires some other measure or adjustment. Since the effect of the new standard on accounting income may be substantial for some entities, the tax consequences should be considered early in the process.
  1. A joint IASB/FASB resource group has been set up to discuss implementation issues. What type of implementation issues do you see this group addressing in the future?

With the new standard the additional guidance will be more useful in accounting for complex transactions. While it is difficult to speculate about the issues that will be considered by the resource group, the one issue likely to be addressed is the consistency of accounting for similar transactions.

Identification and composition of cash generating units Plausibility and consistency of cash flow projections

The following article was originally published by Wiley Insight IFRS.

  1. Are you aware of potential misapplications of IAS 36 [with respect to CGU’s] by reporting entities in your jurisdiction? If yes, are the areas of concern those flagged by the regulators or are there other areas of concern? If you are aware of potential misapplications of IAS 36 are they due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  2. Are you aware of any concerns about the effectiveness of the CGU concept in achieving the objectives of the standard?
  3. Are you aware of potential misapplications of IAS 36 [with respect to cash flow projections] by reporting entities in your jurisdiction in the manner identified by the regulators? If yes, is this due to inadvertent or opportunistic application of the standard, an inability to comprehend fully the requirements of the standard, or for some other reason?
  4. In your view, is the information relating to cash flow projections required to be disclosed by IAS 36 providing investors and other stakeholders with a suitable set of information? If not, in what respects to you believe the disclosures are deficient?

 

Recent misapplications of IAS 36, based on the writer’s experience and the published results of reviews performed by the Canadian regulators, include:

  • The use of overly aggressive cash flow projections when compared to the historical trend for the Cash Generating Unit (CGU). This is a theme in the Canadian jurisdiction which is continuing from the pre-changeover environment.
  • Boilerplate disclosures, for example, where an entity discloses the definition of a CGU instead of specifically describing how the definition has been applied by management.
  • The failure to identify the CGU for which impairment losses were recognized; and
  • Not providing a description and the reason for changing the aggregation of assets into CGU’s, despite being required to do so by IAS 36.130(d)(iii).

The reasons for the misapplication of the standard are difficult to decipher. It does not appear to be through opportunistic application: the reviews performed by the market regulators and audit regulator (the Canadian Public Accountability Board) do not usually result in reissuance of financial statements.

There were some significant differences between IAS 36 and the Canadian standard prior to adoption of IFRS. Furthermore, the adoption of IFRS in Canada coincided with the financial crisis and resulting economic doldrums. The risk of error due to misapplication is also increased for smaller entities that often lack the breadth of experience in applying the standard and the budget to hire outside financial reporting or valuation expertise.

The CGU concept has wide acceptance in the Canadian jurisdiction: ‘CGU’ is a concept applied by the valuation community. In terms of economic reality, entity value is driven by cash generated by groups of assets. The writer is not aware of any concerns about the effectiveness of the CGU model, outside of the details of its application.

Cash flow projection disclosures are required to be made when a CGU includes goodwill or indefinite life intangible assets. The specific detail required where recoverable amount is based on VIU (Value In Use) relates to: the key assumptions, the approach taken by management (that is, past experience or external information), the period projected based on budget or forecast, the growth rate used for extrapolation and the discount rate. In the same scenario, but using FVLCS (Fair Value Less Cost to Sell), the required disclosure includes the period covered, the growth rate and the discount rate.

The cash flow projection information does provide financial statement users with a basis with which to understand the key assumptions behind the forecasts, management’s approach and the mechanics of the exercise. There are still improvements that could be made, however, such as:

  • Details related to cash flows used for measuring recoverable amount are not required (but encouraged) where intangible assets with finite lives are being tested. For many entities that carry long-term non-financial assets the estimation process and the related uncertainties around those estimates are likely to be one of the more significant for users of financial statements.
  • Given the economic uncertainty and the level of risk premiums currently demanded by markets, it seems that this level of disclosure would be useful whenever indications of impairment exist. This would avoid relying on entities applying the general standard in IAS 1.125 for estimation uncertainty.
  • It is possible to reflect the risks inherent in the cash flows through either a risk adjusted discount rate or by adjustments to the cash flows by using an expected value approach. Being informed of the discount rate is of limited use for purposes of comparison between entities. Instead, commentary of which risks are reflected and where would be useful.

The problem in applying the standard could be addressed by management and the audit committee considering the entity’s financial reporting from the perspective of the user.

Technical parameters of value determinations

Growth rates

 5.  Do some entities in your jurisdiction use seemingly high long-term growth rates? If so, do they provide sufficient justification (as required by IAS 36.134(d)(iv))?

6.  Do you observe substantial differences across industries or time due to the issue of growth rates?

7.  How do entities in your jurisdiction incorporate the impact of economic and financial crises into their cost of capital parameters with respect to long-term growth expectations and historically low risk-free rates?

8.  In your view, do entities in your jurisdiction pay enough attention when linking inflation assumptions and the time horizon against which the cash flow is forecasted?

 

Growth rates observed by the writer in recent years have been in the range of 0% to 3% and are based on a variety of factors, including: long-term real GDP growth, inflation rates or expectations, and estimated long-term growth of the CGU considering also historical performance. None of these entities have reflected growth in real dollar terms in their valuation models, and disclosure of the entity’s justification for high growth rates, as required by IAS 36.134(d)(iv), was therefore not necessary.

There is no correlation observed between industries or time, which is a function of the narrowness of the range of growth rates observed.

A public entity that has both traded equity and debt instruments is able to calculate a weighted average cost of capital (WACC) based on those observable markets. For such an entity, any selling of the stock and debt instruments in the secondary market during a financial crisis would increase the cost of capital.

Any entity that has thinly traded equity or debt instruments is forced to estimate the WACC. An estimate would be built-up starting with the risk free rate (such as the long-term bond yield) plus estimates of the other components. In times of crisis when the risk free rate falls market participants would require a higher risk premium, being one of those components.

Such growth rates applied to terminal cash flow values are consistent with current inflation estimates: the Bank of Canada is projecting Consumer Price Index inflation of 1.7% and 2.0% for 2014 and 2015 respectively. If growth is expected to be the same as the inflation rate (so there is no built-in growth over and above inflation to have a positive effect on VIU) then the point is moot. However, if the growth rate used in the model is lower than the expected inflation rate during the time period, there would be a built-in contraction of cash flows for the period beyond the projection. Often this is not explicitly disclosed.

Discount rates

9.  Based on your experience, are the discount rates used by entities consistent with the requirements in IAS 36.55? In particular, do the discount rates reflect the risks specific to the asset and do they reflect the market assessments of those risks and the current market assessment of the time value of money?

10.  Do you experience cases in your jurisdiction of entities not disclosing the respective discount rate that is applied in the context of a value derivation for each CGU that carries a significant portion of goodwill?

11.  How do you assess the severity of a lack of details on the specific discount rates in terms of the reconciliation of valuation results?

 

Entities often provide boilerplate disclosures about taking into account risks specific to the CGU and the current time value of money, without providing any indication as to what asset specific risks have been incorporated into the discount rate. In many cases, it is possible to relate the discount rates used to different business lines only in general terms, but the driver in each case and the exact risks built into the discount rate (as opposed to being reflected in expected cash flows) cannot be seen.

Disparate valuation results can be reconciled, or the differences justified or rationalized, in many ways depending on the circumstances. Take as a simple example, an entity where indicators of impairment are apparent, such as a market capitalization below the book value of assets or operating losses. It seems the disclosures related to impairment testing (and impairment losses recognized) are not driven by any perceived need of the reader to be able to understand that reconciliation process. Indeed, a very detailed disclosure of the build-up of the discount rate in that case, together with the other disclosures required, will not get the reader any closer to understanding why no impairment loss exists.

Similarly, an entity is not required to disclose the assumptions used to determine the recoverable amount when there are indications that an asset may be impaired – disclosure is encouraged but not required.

Comparison of parameters applied by different entities is not possible due to the lack of transparency around which risks are built into the cash flows and which are built into the discount rate. A comparison of discount rates would be meaningless, and potentially misleading, in terms of the relative riskiness of different cash flows.

Conflict between management and external user needs

The following article was originally published by Wiley Insight IFRS.

Conflict is inherent between management’s use of historical financial statements for interpreting and explaining the financial position and performance of an entity and investors’ use which includes comparability between entities.

The ultimate decision to be made is in answer to the question: Should management be permitted to incorporate their discussion and analysis into the general purpose financial statements prepared in accordance with IFRS?

In raising this question, the IASB staff are blurring the distinction between non-GAAP and additional GAAP measures which may also make global regulatory differences more apparent.

A note on terminology and source

The IASB has adopted the terminology of Alternative Performance Measures (APMs) and describes those measures as “competing with” IFRS measures, and as typically receiving more emphasis than the IFRS measures. The equivalent term, non-GAAP measures, is used in this article, and also by the Canadian regulator.

IAS 1 distinguishes between information that is specifically required to be included in financial statements because it is necessary for an understanding of financial position or performance (additional GAAP measures), and any other information that is not required for an understanding or non-GAAP.

The agenda papers in which the staff discuss these and related issues can be found at the end of the article.

Inclusion of non-GAAP information in financial statements

The staff papers contemplate allowing the inclusion of non-GAAP information in general purpose financial statements prepared in accordance with IFRS. Examples include sales per square metre, churn rates and capital expenditure.

IASB staff do appear to be addressing investor needs:

“placing some types of information together, such as management’s plans and strategy together with actual results, can help an entity to tell an integrated story about its financial position and financial performance.”

The Canadian regulators specifically disallow a reporting issuer from including non-GAAP measures in financial statements. Therefore, the change would go well beyond the Canadian rules and be a fundamental shift in international financial reporting.

The change would also bring financial statements more into line with – and indeed, competing with – management’s discussion and analysis (MD&A) which is intended to be written from management’s perspective, “through the eyes of management.”

Issues arising

Under current rules, entities must determine which information is above and beyond what is actually required by IFRS to make the financial position and performance understandable. That is a judgment call. If non-GAAP information is permitted, or required, to be included in financial statements then the difference between GAAP measures and non-GAAP measures becomes academic.

Gross profit and operating profit

It seems clear that presenting non-GAAP information in financial statements would make such differences apparent. For example, the staff provide examples such as gross profit and operating profit as non-IFRS. Global differences in what are considered non-GAAP as opposed to additional GAAP measures already exist. In some jurisdictions those sub-totals would be considered non-GAAP measures by regulators. To avoid regional versions of financial reporting any disclosure standard would have to provide detailed guidance and examples.

Presentation and prominence of non IFRS metrics

Other concerns include that the additional information would draw attention away from the IFRS information, or that it may be “given undue prominence or credibility merely because of its location.” Ultimately, the staff paper concludes that the benefits of bringing MD&A-type discussion and metrics into the financial statements would provide better information for users and would outweigh the concerns.

Audit costs and requirements

The IASB staff consider including such MD&A type discussion and information in the financial statements, but excluding certain information from the audit requirement. This gives rise to a concern about being able to “identify a complete set of financial statements, including, in a set of audited financial statements, whether the information is audited or not.”

Annual financial statements of reporting issuers are subject to audit. The paper points out that audit cost and the sensitivity of disclosing information to competitors would act to control the volume of such information included in financial statements.

What is required to make this happen

The IASB staff considers that the primary financial statements act as a high altitude overview of the financial position and performance of an entity and allow a user of the financial statements to go into more detail in certain areas of interest. In addition, the consistency of presentation also allows a comparison of financial position and performance between different entities.

The information included in the primary statements has a “summary and signposting role” which may be given “undue prominence” by management and “hence receive excessive attention” by users. Therefore the IASB staff recommend that a new disclosure standard would be necessary.

The IASB has approved narrow focus amendments to IAS 1 which are effective for annual periods commencing on or after 1 January 2016 with earlier adoption permitted. Those amendments provide standards that need to me met for an entity to include additional subtotals on the face of the statement of financial position and comprehensive income. The broader discussion over non-GAAP measures continues.

Criteria for inclusion

In serving the needs of the investor community and making historical financial statements more relevant and useful, the IASB is looking to identify the criteria that would need to be in place to allow non-GAAP information to be included in the financial statements or in the notes. Possible criteria suggested by the IASB staff could include:

“(a) be reconciled (where possible) to the most directly comparable measure defined or specified in IFRS and presented in the statement of financial position or performance;

(b) explain why the APM provides relevant information about an entity’s financial position or performance and why the adjustments to the most directly comparable measure …have been made;

(c) be presented and labelled in a manner that makes it clear and understandable what the APMs show and how they are constructed;

(d) provide comparatives and be clear and consistent…from period to period and explain if adjustments have been made…;

(e) not be displayed with more prominence than the subtotals and totals required in IFRS for that statement; and

(f) be clear whether the APM forms part of the financial statements and whether it is audited…on the same basis as the IFRS information.”

Similarly, guidance could also be put in place regarding the presentation or disclosure of items that are non-recurring or that only occur infrequently. And that guidance would include definitions of those terms which are currently not provided in IFRS.

In conclusion

The staff paper concedes that investors find additional measures useful in analysing financial position and performance. At the extreme the IASB staff note that “even APMs that are viewed as being biased can provide information that is useful in assessing management’s character.”

The needs of investors are driving the IASB staff argument for including such information in financial statements, and the IASB is looking to expand the IFRS framework to not only allow, but to encourage, their use within the confines of new reporting rules.

Such a shift in the IFRS financial reporting framework would require the Canadian regulators to change their position to allow non-GAAP measures in the financial statements of reporting issuers.

In the Canadian market the regulators have consistently raised concerns over the biased way in which certain entities have reported results outside of the audited financial statements. It seems clear that requiring an audit opinion to cover all the information included in the financial statements would act as a control over the quality of that information in addition to acting to limit the volume of such content.

Related material

IASB staff papers (February 2015): Disclosure Initiative: Principles of Disclosure

IASB staff paper on the Performance Reporting project (Global Preparers Forum Meeting) March 2015

http://www.ifrs.org/Meetings/MeetingDocs/Other%20Meeting/2015/March/AP9-Performance-Reporting-GPF-March-2015.pdf

Mind the Gap (Between non-GAAP and GAAP) – Speech by Hans Hoogervorst

Korean Accounting Review International Symposium, Seoul, Korea, 31 March 2015 http://www.ifrs.org/Alerts/Conference/Documents/2015/Speech-Hans-Mind-the-Gap-speech-Korea-March-2015.pdf

Neutrality, relevance and comparability of non-GAAP and additional GAAP measures

In the first of a two-part article, originally published by Wiley Insight IFRS, Paul Rhodes, partner at Crowe Soberman, Ontario, examines the use of non-GAAP and additional GAAP measures in Canada and highlights how the relevance, comparability and understandability of a company’s financial statements can be compromised.

Since the adoption of IFRS by Canadian publicly accountable entities with effect from 2011, there has been an increase in the use of non-GAAP and additional GAAP measures. In some cases this is a necessary side effect of the IFRS financial reporting framework objective of ‘general purpose’ financial statements, as a one-size-fits-all approach is unlikely to do just that.

Non-GAAP financial measures

These have been defined by the Ontario Securities Commission (OSC) in Staff Notice 52-722 as a “numerical measure of an issuer’s historical or future financial performance, financial position or cash flow, that does not meet one or more of the criteria of an issuer’s GAAP for presentation in financial statements, and either:

  1. excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP, or
  2. includes amounts that are excluded from the most directly comparable measure calculated and presented in accordance with the issuer’s GAAP.”

In some jurisdictions, non-GAAP financial measures are also referred to as alternative performance measures.

Additional GAAP measures

IAS 1 defines additional GAAP measures presented in financial statements as:

  1. a line item, heading or subtotal that is relevant to an understanding of the financial statements and is not a minimum line item mandated by IFRS (paragraphs 55 & 85), or
  2. a financial measure provided in the notes to the financial statements that is relevant to an understanding of the financial statements and is a measure not presented elsewhere in the financial statements (paragraph 112c).

Qualities desirable of the MD&ANeutrality is required for a faithful representation of economic events in financial statements. Management’s Discussion & Analysis (MD&A) should complement and supplement financial statements. The objective of MD&A is to provide a narrative explanation, through the eyes of management, of how an entity has performed in the past, its financial condition, and its future prospects. Therefore some qualities desirable of the MD&A are the same as those for financial statements. These include, in particular, the requirements that the financial and narrative information presented should be fair, balanced, understandable, relevant and comparable.

The risk posed by the increasing use of non-GAAP and additional GAAP financial measures is that these desirable qualities may be jeopardised. For example, there may be a lack of comparability of financial information between entities, or for the same entity for different periods, meaning that users are potentially unable to identify and understand similarities in, and differences between, items. In a worst case scenario information may not be neutral due to a biased presentation.

To put the issue into context: a study was conducted by the OSC, the results of which were published in 2013, in which the disclosures made by 50 reporting issuers with head offices in Ontario were reviewed. The study revealed that 82 per cent of those reviewed committed to enhancing their disclosures. 

Problems with additional GAAP measures

Operating income

The 1997 vintage of IAS 1 required the income statement to present the results of operating activities as a line item in the income statement. Even though that requirement was subsequently dropped because operating income is not a defined concept in IFRS, it still has a well understood meaning. Some issuers present operating income as an additional GAAP measure but exclude components that would be considered part of operating results. Examples include the exclusion of amortization of acquired intangible assets that are used in operating activities and the exclusion of inventory write-downs.

Gross profit

Other financial statement line items with well understood meanings can also be incorrectly reported (a common example being gross profit), by excluding components that are typically a part of the measure, and conversely, including components that are not part of the measure. 

“Income before the undernoted”

Using terminology that is neither descriptive nor relevant to understanding the financial performance or position, such as ”income before the undernoted” or “income before operating expenses”. Similarly, the inclusion of unlabeled subtotals in the financial statements is unlikely to contribute to an investors’ understanding.

Boilerplate language

The use of boilerplate language, instead of explaining why the additional GAAP or non-GAAP measure is relevant to investors’ understanding of the financial statements, is problematic. A reporting issuer often makes no reference to the measure in either the notes to the financial statements or in MD&A, which casts doubt on the relevance of the measure to understanding financial position and performance.

Problems with non-GAAP measures

”Weighted average yield”

The use of undefined or ambiguous performance measures can be confusing and potentially misleading to investors. For example, disclosing, in MD&A or press release, undefined measures of performance, such as a “weighted average yield” applied to financial instrument receivables accounted for as loans and receivables at amortized cost using the effective interest method.

Furthermore, the inclusion of such a measure in the financial statements may reasonably lead investors to conclude that the measure is a standard GAAP measure that is required to be disclosed, especially in other public documents when there is inadequate disclosure and no reconciliation is provided between the measure and the entity’s GAAP financial statements.

Reconciliation issues

Not providing a clear quantitative reconciliation between the non-GAAP financial measure and the most directly comparable GAAP measure. Such omissions leave investors having to make assumptions about the composition of the non-GAAP measure.

Management bias

Clear management bias in presenting non-GAAP measures, such as including one-time gains but excluding one-time losses in other periods, or by describing measures as excluding non-recurring items when those items are seen to recur within a short timeframe. When items are removed from the GAAP measure of performance to arrive at the non-GAAP measure the nature of the item removed and why it is not expected to recur is rarely provided.

Management bias can also occur where the non-GAAP earnings measure is presented more prominently than the equivalent GAAP measure, or where the GAAP measure is excluded entirely. Earnings releases often include a level of analysis applied to non-GAAP measures that is not applied to the equivalent GAAP measure.

Sheer volume

Investor confusion may be increased by issuers including many non-GAAP measures of performance in a public document with only slight differences between each.

The problems identified above are not new to the IFRS world in Canada. Clearly, there is a need for reporting issuers to be allowed to present measures of financial performance or position suitable to their respective business. However, the Canadian market regulators have had issues with the use of non-GAAP and additional GAAP measures for many years. A subsequent white paper will review in detail the IFRS and Canadian regulatory rules on the use of these measures, and also position that guidance within the global context.